LONDON Japan may lose this year's top billing on global stock markets as a boost from a weakening yen is likely to wane in a country where exports make up less than a seventh of total economic output.
The correlation between a falling currency and rising local stocks has already dropped back from its peak and the equity market may require a strong pick-up in domestic demand to drive further gains from here.
The "Abenomics" policy agenda pushed by Japanese Prime Minister Shinzo Abe - a mix of monetary easing, stimulative spending and growth-inducing steps - has driven the yen lower and propelled the stock market past those in other developed countries.
Well-known brands of Japanese cars, televisions and games consoles support a popular belief that Japan is an export-oriented economy which would benefit from a weaker currency.
Yet goods exports in fact account for only 13.5 percent of gross domestic product, almost the same as the euro zone and not much more than the 10 percent in the United States, according to data from the IMF and JP Morgan.
Moreover, companies on the MSCI Japan index derive 35 percent of sales revenues from abroad, less than 40 percent for the United States and 66 percent for Europe.
"It is a surprise we have this perception that it's an export-oriented economy... Maybe there's overemphasis on the significance of the yen on the equity market," said Dan Morris, strategist at JP Morgan Asset Management.
"It's reasonable to expect the correlation to weaken once people become less obsessed with Japan. Then we go back to (companies) having to improve profitability and domestic revenue growth because it's not going to be enough just to have the currency depreciate."
Japanese stocks .MIJP00000PUS have risen 22 percent in dollar terms this year, ahead of the United States which has gained 17 percent. This closely mirrors the move in the yen, which had lost a fifth of its value against the dollar at one point this year.
But the benchmark Nikkei index .N225 is off 8.6 percent from the 5-1/2 year high set on May 23. Correlation between Nikkei and dollar/yen exchange rate peaked at 0.66 in mid-June, before falling to 0.47 this week.
The 13-year average is just 0.1 - meaning almost no correlation between the performance of the stock market and the level of the currency - and it has had negative correlations in the past.
Expectations are indeed running high in Japan. The IMF has just upgraded its growth forecast for Japan, which is going to be the fastest growing economy among advanced nations this year.
According to Thomson Reuters data, corporate earnings are expected to rise 22 percent on the year in the second quarter, compared with 2.3 percent in the United States and just 0.6 percent in Europe.
Money heading into Japan equity mutual funds has fallen back sharply from the Abe-inspired free-for-all of April and May. After two months of net inflows at $12.5 billion, June saw a more sedate $1.7 billion invested, according to estimates by Lipper.
Long-term investors are more confident on other developed markets than Japan. Fourteen percent of pension fund managers polled by Baring Asset Management said the United States had the biggest potential for equity gains over the next decade, compared with 4 percent in Europe. None chose Japan.
Abe is expected to decisively win an upper house election this month. But some fear too big a win may weaken commitment to reforms needed to end the stagnation that has long plagued the economy.
Valuations may also become a problem. The 12-month forward price-to-earnings ratio stands at 14.3, below the 10-year average but the most expensive in the world after Mexico.
In the long term, Japanese companies will also need to raise their profitability. Return on equity - the amount of net income returned as a percentage of equity - for Japan, using the MSCI index, stands at 8 percent, half that of the United States and compares with 12 percent in Europe.
"It is fair to say that, with hindsight, the enthusiasm for 'Abenomics' overtook what could realistically be delivered in the near term," said Paul Niven, head of multi-asset investment at F&C Investments.
Niven has halved his overweight positions on Japan.
"While the injection of vast amounts of liquidity is helping consumption and the real estate market, capital expenditure is yet to improve and the yen remains volatile."
(Additional reporting by Joel Dimmock; Editing by Toby Chopra)